25 September 2018
Open-ended UK property funds have long been a staple for many pension schemes. They offer exposure to a range of different properties, low levels of gearing and regular liquidity (in theory – more on this later).
While many investors simply want a property market return to diversify equity exposure, it’s important to remember that ALL open ended funds are managed on an active basis. It is hard to find an open-ended fund that consistently outperforms its peers.
Performance ups and down
Did you know that:
• over the last 10 years, all but two of the 15 largest open-ended funds popular with pension schemes have experienced at least one prolonged period (ie three years or more) of under-performance?
• size doesn’t matter? The three most popular funds have all under-performed the market consistently over the last 5 years!
Many investors only invest in one open-ended fund, happy that this should provide sufficient market diversification. History tells us though that, with this approach, investors should not be surprised by a period of prolonged under-performance in the future.
Based on my experience, clients will often tolerate some under-performance if the UK property market as a whole is performing well, particularly as high transaction costs (eg stamp duty) are a barrier to changing funds. In more challenging markets however, disappointing performance can trigger change, and expose the illiquidity of open-ended funds. In a falling market, property can be hard to sell. In the last property crisis (2007-9), redemption pressure forced several managers to sell at distressed prices, and led some to impose a gate on funds, suspending redemption requests. This often exacerbated under-performance for schemes that remained invested.
The difference between the best and the worst performing fund over this two-year period was 41%. In subsequent years, five funds that were previously popular with pension schemes closed permanently or underwent significant (and costly) restructures.
Fund specific risk can be significant for investors if things do go wrong.
So why raise this now? Well, I see some headwinds for UK property on the horizon, so I believe it’s important for investors to understand this risk and, if possible, take steps to mitigate it. This can be easier to do than you think.
Multi-managers can spread the risk
A specialist property multi-manager can reorganise a single-fund holding into several bite-size chunks across a range of different open-ended funds.
This is a simple way to spread the risk. With this approach the under-performance or collapse of any one fund would have much less of an impact on your portfolio. A collection of funds is also more likely to track the property market index. I believe that many schemes would prefer this to the ups and downs of one actively-managed fund.
Transitioning into a multi-manager product from your existing property portfolio may not be as expensive as you think. Multi-managers widely use secondary market property brokers which can significantly reduce the transaction costs involved. Brokers match buyers and sellers of open-ended funds. Sometimes (although not always) it’s possible to purchase funds at a discount to NAV, or sell funds at a premium. We’ve seen examples of a multi-manager reduce reorganisation costs of an under-performing fund by 70%, reducing the transaction cost from 7% to just over 2% – so for a fund under-performing by 1% each year, the pay-back is only two years.
For some outperforming funds, multi-managers may be able to sell at a price above NAV locking in an extra premium.
Additional fees of a multi-manager approach can be less than 0.2% pa - relatively modest considering the reduction in risks. And I think that using a multi-manager helps future-proof the strategy. Many schemes will want to rein back their property allocation as they de-risk - with a mix of funds and efficient use of brokers to provide liquidity, the chances of a bad outcome for schemes selling in a troubled market, or being stuck in a gated fund, reduce materially.
As the old adage goes don’t put your (property) eggs in one basket. Or as a good bricklayer would say (apparently) don’t put all your bricks and mortar in one hod!